Strategic Asset Allocation Scott

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Strategicsset llocationor ension unds

Rsum

Philip. ScottNorwich nion nsuranceroup, O Box 4, urreytreet,orwich R1 3NG, UnitedKingdom

SummaryStrategicsset llocations he ost mportantecisionor ny ensionund. It remains,howeverhe eastnderstood.There s o rightr rong ay of etermininghe trategicsset llocationnd in the endit s questionf findinghe est olutiono a set f constraints,ome implicitfundstructure)nd ome xplicitlegislation).his olutionill lso e heavilynfluencedythe ersonalhilosophiesf the investor.An agreedtrategicsset llocationenchmarks he italay in hich he hoicehatasbeen ade an e communicatedo ll arties.nly n hisay can he nvestmentrocessbe nderstoodnd he esultseasuredo nsurehe und chievests ltimatebjective fprovidingenefitso tsembers.This aper s ritteny an nvestmentanager who s lso n ctuary)nd t rieso akepracticalpproacho he evelopmentf trategicsset llocationtructures.

Rpartitiontratgiquees ctifsour les Fonds de RetraiteLa rpartitiontratgiquees ctifsst a cisiona lus mportanteour out onds eretraite.lle esteependanta lus connue.Il y pas e onne u de auvaiseaon e terminerne partitiontratgiqueactifset n fin e compte, ela e rsume rouvera eilleureolution n ensembleecontraintes,ertainesmplicitesstructureu fonds)autresxpliciteslgislation).ettesolutionera galementortementnfluencear les philosophiesersonnelleselinvestisseur.Un repreonvenue partitiontratgiqueactifsst a aon ssentiellee communiquerle hoix ffectu outeses arties.e nest ue de cetteaon que le processusdinvestissementeut treomprist es sultatsesursour arantirue e ondstteigneson bjectifltimeui st e ournires llocations es membres.Cet rticlest critar n gestionnairee placementqui st galementctuaire)t tentedadopterne pprocheratiqueu dveloppementes tructurese rpartitiontratgiquedactifs.

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2nd AFIR Colloquium 1991, 3: 33-49


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1.7 The asset tructuref any long-term fund, like a pension fund,needs to be decided sing ong-term ime horizons.his long-term target for the fund is generally known as the StrategicAsset Allocation tructure. t should take account of theliabilitiesf the fund and actuarialkillsave an importantpart to play in determining the Strategic sset Allocationstructure.

1.8 Equities old a clear dvantage in matching the attributesflong-term nflationinked iabilities.t is therefore cceptedwisdom in the UK that he natural osition or pension fundis to be heavily nvested n equities.owever, short-termreturns from equities re highly volatile nd thereforeproportion f other ssets hould be held to diversifyhis riskand ensure hat iabilitiesan be met.

1.9 This leads o the crucialuestion for all investors:How much of the fund should be in equities?There is o simple answer to this uestion nd views will eheld by both the investment anager who looks fter heassets nd the actuary ho looks fter he liabilities.hispaper is written y an investment anager (who is also anActuary) and it ries o take a practical pproach to thedevelopment of the Strategicsset llocationtructure.

1.10 Deviations rom the long-term sset tructurean often econsidered esirableecause of short-termxpectationsboutthe return rom the differentsset ypes. his s acticalssetAllocation,hich is ot a subject or his aper and shouldnormally e delegated o the day to day investment anagerof the funds.

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2 A s s e t S t r u c t u r e s2.1 The actual asset structures of pension funds differ significantly

between one country and another. For example:

Ta b le 1B r e a k d o w n o f p e n s i o n f u n d a s s e t s b y t y p e - 1 9 8 9

UK%Equities 78Real Estate 10Bonds & Cash 12Source : Various

2.2

2.3

Netherlandsermany France Japan USA% % % % %38 15 26 27 4716 10 - 1 446 75 74 72 49

Care needs to be exercised in comparing the data, not leastbecause of very different valuation methods in differentcountries. However, the differences are sufficiently large for usto try and find out why they exist when the funds are seekingto achieve the same aim.UK Pension FundsUK pension funds have traditionally had higher weightings inequities than pension funds in any other country. Theimportance of equity investment has existed for many years ascan be seen from the following table.

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Ta b le 2As se t D is t r i b u t i on - U K P e n s i on F u n d s

1965%

U K Eq u i t i e s 50O v e r s e a sE q u i t i e sR e a l E st a t e 5B o n d s 42Cash 3Source : Central Statistical Office

1970 1980 1 9 9 0% % %56 44 53

6 2110 22 1032 23 102 5 6

2.4 One of the main reasons for this equity bias is the inflationaryexpectations in the economy. The UK has had a high rate ofinflation relative to many other countries and real assets, suchas equities, have been important in achieving real (ie inflationadjusted) returns. Bonds on the other hand tend to fare badlyin times of high inflation. See below :

T a b l e 3Period UKAssets- RealRatesof Return

Bonds Equities% %

1950 to 1959 -2.5 +13.81960 to 1969 -1.9 +4.21970 to 1979 -4.9 +1.81980 t o 1989 +6.9 +15.3Source : BZW Equity-Gilt Study

%AverageRateof Inflation

+4.1+3.8+13.3+6.8

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2.5 In the UK attitudes towards inflation have clearly influencedStrategic Asset Allocation. Whilst this is true in other countries,there are also many other factors.

2.6 statutory controlsAll countries have their own particular control mechanisms forthe management of pension funds. In the UK there has beenconsiderable freedom to invest, whereas many other countrieshave tended to apply investment restrictions to pension fundseg setting a maximum on the percentage invested in equitiesor the minimum that must be invested in Government bonds.

2.7 In the US, pension funds have been heavily influenced by theERISA legislation and in Japan the Ministry of Finance hasinfluenced asset allocation. All Governments will use theirinfluence to a lesser or greater degree to ensure that benefitpromises are met and the investment activity fits in with othereconomic and political objectives.

2.8 Governments need to raise capital and the nature of thatcapital will itself impact upon pension funds as they are oneof the main sources of such funding: For example, in the UKpension funds were investing more in Government Bonds inthe 1970s because of the Governments substantial borrowingprogramme. In the 1980s, the British Government raisedcapital through the disposal of shares in privatised companies.This was one of the reasons for the 1980s being a decade ofincreased equity weightings.

3 A t t i t u d e s3.1 Strategic Asset Allocation should produce a target long-term

distribution of assets. It is therefore natural to seek expertadvice to formulate the right answer. However, comparisonof the different approaches taken around the world shows thatthere clearly is no single right answer.

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3.2 Strategic Asset Allocation is not purely a mathematical processand involves many intangible considerations. In fact, theinvestors attitudes can have the most significant impact uponStrategic Asset Allocation. For example :. Is high or low inflation expected?. Is international investment to be encouraged or should

the investor remain loyal to his countrymen and invest inthe home market?

. Should the investments be linked directly to marketvalues or be placed with an institution which shelters thepension fund from fluctuations in market values (ie aninsurance scheme)?

. Is investment in the employer's business to beencouraged or avoided?

3.3 FrameworkHaving answered these questions, it is possible to develop theframework in which the Strategic Asset Allocation structurewill be developed. The starting point is to establish a set ofphilosophies which will form the basis of the structure. Thesemay include :We believe in the long term that equities will provide a returnin excess of bonds. We believe that international investment provides diver-sification and thereby reduces the fluctuations in the totalreturn from the portfolio and provides the opportunity to investin different economies.

3.4 Such a framework seems at first sight to be a very flimsyframework for such an important decision as a Strategic AssetAllocation of pension fund assets, It is, however, the reality ofhow such decisions are made. There can be no certainty thatequities will out-perform bonds but an investor must believe itif the asset allocation is to have a high weighting in equities.

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3.5 Some investors will regard substantial equity investment as toorisky for their pension fund. If so, then the Strategic AssetAllocation structure must reflect this desire for caution byincluding a much higher weighting in bonds or otherdiversifying assets.

4 M o d e l s4.1 The weakness of basing the Strategic Asset Allocation decision

upon a collection of philosophies can be overcome to someextent by using computer simulation techniques. However, itis important to remember that a model can only illustrate theoutcome of different asset structures. This is because theoutput is highly dependent upon the input which in the caseof investment models always includes subjective judgement.

4.2 Asset Allocation models using the optimisation techniquesdeveloped under Modern Portfolio Theory can be used tosimulate different asset structures. Many such models can bebought cheaply to run on a personal computer. They tend totake the form :I n p u t s. Expected rates of return from the different asset type.. Expected risks (as defined as the standard deviation of

returns).. Expected correlations amongst the assets.o u t p u t s. Efficient Portfolios for different levels of risk (as defined).. Illustrations of the probability of the fund obtaining a

negative return in a particular year.

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4.3 Such models can be used as a tool for maximising returns forDefined Contribution funds given the chosen level of risk butthey do suffer from the weakness of not taking account of theliabilities when used for a Defined Benefit pension fund. Thisweakness can be overcome to a large extent by the use ofAsset/Liability models.

4.4 Asset/Liability models can help in developing a Strategic AssetAllocation structure which is the most efficient portfolio givenboth the actual and expected liability profile of the fund andthe preferences of the investor. They can take account of thefunds surplus position and the nature of future contributions.

4.5 It is not a purpose of this paper to develop further the detailin respect of Asset/Liability models. Most consulting actuariesoffer services in this field and, in my view, they represent asignificant step forward in the contribution that actuaries canmake to the Strategic Asset Allocation decision. The resultswill always be very sensitive to the assumptions made, manyof which are highly subjective. However, if the assumptionsused are consistent with those used in calculating thecontribution rates then much insight is gained.

5 E c o n o m i c T r e n d s5.1 The Strategic Asset Allocation decision should only beinfluenced by the expected long-term trends such as inflation

and the yield from bonds and equities. Shorter term viewsshould be taken into account by the investment manager inhis Tactical Asset Allocation.

5.2 The global shortage of capital arising from fundingPerestroika, the US budget deficit and the banking systemsreserve ratio requirements is one long-term trend which islikely to increase the return from bond investments. My own

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philosophy for the 1990s is that equities will continue toprovide greater returns than bonds over the long term but thatthe difference between the return from these two asset typeswill be smaller than existed in the 1980s.

5.3 In Europe, the economic convergence triggered off by the1992 initiative will also impact upon the relative attractivenessof equities and bonds. From a UK investors perspective thiscould also lead to an increased weighting of bonds,particularly if the UKs entry into the Exchange RateMechanism is effective and there is a sustainable lowering ofinflationary expectations in the economy. There is also likelyto be a greater supply of bonds as the UK Governmentresumes its funding of a new budget deficit.

6.1 There are a number of parties to the Strategic Asset Allocationdecision :. The governing body of the pension fund (trustees in the

UK). The finance director of the company sponsoring the fund. The investment manager charged with day to day fund

m a na ge m e n t. Any Consultants including the Actuary.

6.2 Strategic Asset Allocation cannot be delegated to any one ofthese parties alone since the asset allocation decision needs totake account of all risks - although the risks are differentfor the various parties.

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6 Strategic Asset Allocation-Whose decision is it?


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6.3 To the chairman of the governing body, the risk is that thefund fails to fulfil the benefit expectations of the membership.To the finance director, the risk is that poor asset allocationmay cause a need to increase funding and hence cause adrain on the resources of the company. To the investmentmanager, and the consultant, the risk is that they will losebusiness if the fund is not managed correctly.

6.4 Some of these risks can be quantified but many are qualitativein their nature. As pension funds grow in monetary value, it isnatural to seek more and more sophisticated quantification ofthe risks.

6.5 Most people would agree that the medical profession are theexperts on medical issues. For investment issues, however,everyone considers themselves to be an expert on theinvestment of funds of limited size. A poor man will decide onhis investment of $100 in a savings account, whereas anexpert is needed to decide how to invest $1,000 million.

6.6 The question remains, who is the expert on Strategic AssetAllocation? I would argue that the expert does not exist andStrategic Asset Allocation should be viewed as an agreementbetween all parties, each of which has their expertise to addto the final decision. The importance being that the issues arediscussed and agreement is reached from the differentperspectives.

7 B e n c h m a r k s7.1 One of the best ways of confirming this agreement is to

establish a Benchmark asset structure which is the normalstructure for the fund. Such a Benchmark can be used tomonitor the progress of the fund and be the neutral portfoliofrom which to determine whether the actual investmentoutcome has been successful or not.

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7.2

7.3

7.4

The poor man mentioned previously will consider hisinvestment successful if his capital of $100 is secure and willprobably regard any interest on the money as a bonus. Hisimplicit Benchmark is 100% in cash.For those responsible for the management of pension fundassets, then clearly a Benchmark of 100% in cash is almostalways inappropriate, not least because the pension fundneeds to obtain real rates of return. Too often, however,investors of pension funds do not have an agreed Benchmarkand are also unaware of the implicit Benchmark being usedby the investment manager of the fund. This greatly increasesthe chance that the investment outcome will disappointbecause the objectives are not clear at outset.A Benchmark for a pension fund can typically be expressed inthe form of long-term target distribution or range ofdistribution of assets. For example :

Ta b le 4I llu s t r a t i v e B e n c h m a r k fo r a U K P e n s io n F u n d

Asset

U K E q u i t ie sNon-UKE q u i t i e sR e a l E st a t eB o n d sC a s h

Target%5525

515

0100

or Range%

50 - 6 015 - 300 - 1010 - 200 - 10

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7.5

88.1

8.2

Benchmarks can remain as fixed percentages or beautomatically updated for the relative movements betweenasset types. As described above, the Benchmark can bederived from a detailed technical analysis, such asAsset/Liability modelling, or alternatively it can be derived bychoosing an investment strategy with an Implicit Benchmark.

I m p l i c i t B e n c h m a r k sMany pension fund trustees and consultants in the UK continueto regard performance relative to the average pension fund as ameasure of the success of their investment managers. In my viewsuch a belief means that by default they are using the averagepension fund as an Implicit Benchmark. This Benchmark maystill be an appropriate way of determining Strategic AssetAllocation for average pension funds but care needs to beexercised for Defined Benefit funds to ensure that the liabilityprofile does not require a different approach to be taken.Data is readily available on the actual asset structure of theaverage fund and the total return achieved from such a fund.For example :

Ta b le 5WM Universe of UK Pension Funds

%AssetType1985 1986 1987 1988 1989

Equities 66 71 68 69 74Real Estate 11 9 10 11 10Bonds & Cash 23 20 22 20 16

100 100 100 100 100Annual Rate of Return 14.5% 22.5% 3.4% 13.8% 30.3%

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8.3 Trustees may feel that by setting an objective for the fund toout-perform the average fund then there is no need toconsider the Strategic Asset Allocation decision because thishas been delegated to the investment manager. In practice,most investment managers who take on the Strategic AssetAllocation decision for the client do in fact ensure that theasset structure does not deviate too far from the average ascan be seen from the following table.

Ta b l e 6Distribution of Discretionary UK Pension Fund AssetsProportion in Equities (as at 30.6.90)

Source : Mercer Fraser

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8.4 The average roportion n equitiesf this ample of UK basedinvestment anagers of pension funds was 77% a s at 30 June1990. hese managers had full iscretion ver both theStrategic nd Tactical sset Allocation ecisions. hosemanagers who are within ay+ or 10% of the average quityexposure (shaded portion) re likely o be using his verageas an Implicitenchmark.

8.5 Those investment anagers whose asset istributions verydifferentrom the average re taking ubstantialusiness risksin that the investment outcome is likely to be significantlydifferentrom that f the average fund. In such cases it sdifficulto identifyhe approach being taken towards StrategicAsset llocation.

8.6 During the last 0 years in the UK the highest eturns avealmost always been achieved from equities and a StrategicAsset Allocation f 100% in equities as produced the bestfund performance. owever, during the 1990s t s xpectedthat returns will be far more volatile nd to allow theinvestment anager to invest p to 100% in equitiess highrisk trategy,ven for rapidly rowing fund.

8.7 Therefore here the investment ecision s delegated o aninvestment manager there is still need to agree on theStrategicsset Allocation enchmark in order that here isagreement between all artiesn the investment bjectivesfthe fund. Put another way, if he fund does not have anExplicitenchmark then there hould be an understanding fthe Implicit Benchmark and the degree to which theinvestment anager will eviate rom that enchmark.

8.8 It an be said hat sing he average und as a Benchmark issimply following the herd. I would argue that a skilledmanager can stillroduce superior eturns rom TacticalssetAllocationy being the ight istancerom the herd at the righttime e he will e overweight n equitiesn risingarkets ndunderweight n allingarkets elativeo an agreed enchmark.

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9 Defined Contribution PensionFunds

9.1 Since a Defined Contributionension fund does not promiseto provide pecificetirementenefits hen the StrategicssetAllocation ecision oes not need to take specificccount ofthe liabilities.owever, it s stillecessary o determine anExplicit enchmark or choose an investment ype with anImplicitenchmark.

9.2 In a Defined Contribution fund the member will usuallyreceive he investment eturns dded to his account ie themember is aking he investment isk nd not the fund or hisemployer. t s herefore tilln important uestion s to howmuch equity content should be within the Benchmark,particularlys the member nears etirementge when adversemarket fluctuationsan adversely ffectenefits.

9.3 One solution s or he Benchmark to include high weightingin cash or short-term onds although his s ikely o lead tolower returns. lternatively,he investment ould be madewith an institutionhich itselfas a high exposure to equitiesand offers nvestments hat smooth the fluctuationsn thereturns o the members.

9.4 In the UK the long establishedWith Profitunds of the LifeInsurance ompanies are an ideal xample of such an assettype. n developing he Strategicsset llocation enchmarkfor Defined Contributionension fund one should considerincluding uch investments.

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10 Conclusion10.1

10.2

10.3

10.4

10.5

All those involved with the investment management ofPension Funds should understand the Strategic ssetAllocation enchmark being used for the fund. his shouldform a major part of the agreement amongst those responsiblefor the fund.The type of Benchmark chosen should take account of theliabilitiesf the fund but will iffer onsiderably rom onecountry to the next. his is because of differingttitudes,investment expectations and a variety of investmentconstraints.Simulation echniques an be used to determine he array fpossible outcomes of a particular investment strategy.Wherever possible xplicitenchmarks can then be set.If the strategicsset Allocation ecision s delegated o aninvestment anager then it emains necessary o understandthe Implicitenchmark. If his annot be establishednd themanagers strategy s significantlyifferentrom the averagethen performance esultsan be erratic.Finally, or Defined Contribution funds it should beremembered that it s often the case that the member isbearing the investment risk. ome form of risk sharinginvestment rom insurance ompanies should be consideredas part f the investmentsor such funds.

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Strategic Asset Allocation Scott